Here is the PDF of Dion Cornett's January 13 report on SCO. As you will see, the OSDL legal defense fund, the Novell indemnification, and the Open Source Risk Management vendor-neutral indemnification program seem to him meaningful events, which he believes make it unlikely end users will now want to purchase a license from SCO in 2004. "The 'safe' action for the reasonable executive has switched from license to fight," says the report. Here's a segment.

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End-user visibility worsens as Linux community raises defenses

We believe it is now unlikely that SCO will generate meaningful end-user SCOSource revenue in 2004.

Investment Considerations:

Yesterday an industry consortium of Open Source-related companies (OSDL) announced an IP defense fund for endusers;

In conjunction with its closing of the SuSE acquisition, Novell announced an indemnification program for its customers;

We have cut our previous SCOSource revenue estimate of $7 million by 90%;

Our new FY04 GAAP EPS estimate is a loss of ($.43) down from a $.20 profit;

Our new target price is $5 down from $8;

We maintain our Underperform rating.

Investment Summary

Our outlook for SCO has worsened given yesterday’s news that an Open Source industry group has formed a fund that may be used to defend end-users from SCO claims. Contributors to the fund include technology giant Intel (INTC: not rated). Novell (NOVL: Market Perform) piled on late in the day by announcing an indemnification program for its customers. Coupled with Novell’s previous filing of overlapping UNIX copyrights, we believe that end-users, already reticent to license from SCO, now have three justifiable reasons to wait to pay SCO even if SCO’s claims are eventually proven valid.

More blows to SCO’s end-user licensing efforts

We believe yesterday’s news that an industry consortium, Open Source Developments Labs (OSDL), had established a fund to defend end-users against infringement claims, represents the third strike in SCO’s attempts to derive IP-related licensing revenue from end-users. The first couple items detailed in our prior reports include the ambiguity of SCO’s claim over header files and Novell’s copyrighting of duplicitous UNIX software code.

Previous benefit of the doubt goes away

Furthermore, we previously had assumed that SCO would be able to generate $7 million in SCO Source licensing revenue this year. As stated in our prior report, "The ability to win end-user settlements is based on our presumption that SCO will be very careful in choosing its initial targets. Suing the wrong end-user early on, one that is willing to fight, poses several problems for SCO. An end-user willing to fight could mean higher legal fees, management distraction, and further Linux community scrutiny of SCO’s claims. More importantly however, the end-user does not even need to fight to victory to damage SCO’s ability to collect licensing fees. In our opinion, the first end-user that successfully wins a stay of proceedings pending the outcome of the IBM (IBM: not rated) or Red Hat (RHAT: Outperform) cases effectively could shut SCO’s efforts down as detailed in prior reports."

Legal expenses remain even as SCOSource revenue shrinks

Now with the potential for legal costs to be borne by OSDL, whose defense fund contributors include heavyweight Intel, we now believe it may be difficult for SCO to win any settlement. Furthermore the “safe” action appears to have switched sides. Before, many organizations may have been willing to write a five-figure check to avoid legal risks and move on with business. We suspect anyone currently considering such an expenditure may now worry that they will be taken to task for wasting corporate funds. As a consequence, we have reduced our expectation for FY04 SCOSource revenue by 90%. Similarly our estimates for legal expenses have also increased in anticipation of more expensive initial end-user battles. Based on the pace of legal proceedings, it is highly unlikely SCO will be able to post a legal victory against an end-user this calendar year, even if it were to file an end-user lawsuit by mid-February as it discussed.

More entities announce plans to oppose SCO

Later in the day, in what might be described as piling on, it was reported after the market close that Novell would indemnify its Linux customers. The indemnification program would apply to customers purchasing SuSE Enterprise Linux 8.0 after January 13, 2004. The timing of the indemnification corresponds to Novell’s expected and announced completion of SuSE GmBH (In a separate announcement last night Novell announced that the acquisition of SuSE had closed. ) Also this morning, in an interview reported on Groklaw, Daniel Egger, chairman of the Open Source Risk Management Group, announced plans for a vendor-neutral indemnification program. The program would operate similar to insurance for companies supplying and using Open Source code and its agnostic approach is meant to eliminate the vendor lock-in, and potential fragmentation, inherent with vendor specific indemnification.

STOCK OUTLOOK

Increasingly binary outcome steps up risk

With significant end-user licensing fees unlikely and cuts to the core business possibly necessary, the fortunes of SCO’s shareholders are increasingly tied to a victory or loss against IBM. Yet, with the jury stage of the IBM lawsuit not scheduled to commence until April 2005, SCO is at least two years away from a potential win against IBM. Thus, the near-term downside risk to SCO’s shareholders is greater than the upside potential as IBM could conceivably win a motion to dismiss at least portions of SCO’s complaint at almost any time during this same period. The legal doctrine that supports this assertion is that juries decide facts, while judges decide matters of law.

Near-term catalysts lean negative

Over the next few months a number of events offer the potential to drive SCO’s stock price. Yesterday, SCO was required by a Utah judge’s December order to provide with “specificity” to IBM a list of files that form the basis of its complaint. While the materials presented are covered by a protective order, we believe SCO may attempt to release additional details over the next few weeks to bolster its case to the IT community where it appears to be losing the public relations battle as of late based on Linux’s momentum. The risk to SCO is that the Linux community, which consists of potentially thousands of free programming experts for every one expert that SCO hires, is able to quickly counter SCO’s claims. SCO’s management also points to the likely granting of its own motion to compel discovery against IBM and positive responses from its end-user certification letter as other potential near-term catalysts. Negative near-term catalysts include the expected denial of SCO’s motion to dismiss the Red Hat lawsuit and IBM potentially filing to dismiss portions of SCO’s complaint. The filing of an end-user lawsuit will most likely be touted by both bears and bulls on the stock as a positive for their position. We believe that in total the near-term catalysts are generally negative for SCO.

Deteriorating metrics likely to drive price in 2004

Beyond the ebb and flow associated with a tightly-held, volatile stock, with strong opinions on each side, we believe SCO’s stock price direction over the next year, will be dominated by its expected declining financial position. As legal expenses increase with limited offsetting SCOSource revenue, the declining cash balance is likely to become a concern. Furthermore, year-over-year comparisons are likely to be poor starting in April given that the $26 million in SCOSource revenue received from Sun (SUNW: not rated) and Microsoft (MSFT: not rated) is not likely to be repeated. This begs a question for SCO bulls; if an expected $45 stock price is two years away, but that expectation may drop to single digits at any point in the interim, why assume the risk and hold the stock today when fundamentals like cash per share and revenue growth will get worse before they get better? This risk return equation does not require a judgment on whether SCO’s claims are valid and potentially produces higher returns by facilitating a lower entry point and shorter IRR period.